Class Notes - WEEK 6 (Oct 15, 16, 21); Chapter 7 - COMM 2AA3

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School

McMaster University

Department

Commerce

Course

COMMERCE 1BA3

Professor

Aadil Merali Juma

Semester

Fall

Description

WEEK 6 COMM 2AA3
Chapter 7: Reporting and Interpreting Sales Revenue, Receivables and Cash
October 15, 17, 2013
Sales Revenue
 Many companies try to overstate revenue – accounting income is not taxable income; overstate to maximize return to
shareholders; more revenues, more support from shareholders, which reflect in stock prices
 Revenue Recognition Principle – recognize revenues when
1. The earnings process is complete or nearly complete (service performed)
 Transfer of ownership – reasonable assumption that service has been performed
 Shipping term – (F.O.B = free on board; freight on board)
 F.O.B Shipping Point – the title of goods passes from the seller to the buyer at the sellers point of sale
o If damaged in transit; buyer is responsible
o Auditors want to see that goods have been received; other wise revenue is overstated
 F.O.B Destinations – the title of goods passes from the selling to the buyer when the goods are
delivered to the buyer
o Property of seller until reaches buyer; insurance/liability is sellers responsibility
 Eg/ Dec 21 end of fiscal year; FOB Shipping Point; in transit; inventory recognized on buyer balance
sheet; revenue recognized by seller
 Risk transfer may be a better method than title transfer, to determine reasonable assurance of collection –
title transfer is sufficient
 Sales revenue is reduced by (contra-revenues accounts); debit balance because revenues are usually credited
1. Credit card discounts – credit card companies charge a fee
o Eg/ customer pays $20, credit card company takes $1 (credit card discount), business
receives $19
o Companies accept credit cards for several reasons (even though revenue is lost to credit card
companies):
 To increase sales
 To avoid providing credit directly to customers
 To avoid losses due to bad checks – hurt credit history and incur huge charges
 To receive payment more quickly – checks can be post-dated, credit is instantaneous
 Default on credit card payments are not incurred by business, but by credit card
company
 Credit card collections are liquid – cash
2. Sales returns and allowances
o When customers are sold damaged merchandise, they can either
 Return the merchandise and receive a full refund  sales returns
 Keep the merchandise but receive some credit (either reduction in A/R, store credit,
or cash)  sales allowance
 Credit
 Cash return – reduces cash
 Can reduce A/R
 Credit note; can use it to purchase more goods (credit like a liability, similar
to owing them money)
 Debit losses (if thrown away) or inventory (if took merchandise back)
o Refer to Accounting for Bad Debt (below)
3. Sales discounts (cash discounts) – discounts given to customers to encourage early payment; most
common
o When companies allow customers to purchase merchandise on an open account, the
customer promises to pay the company in the future for the purchase
o When customers purchase on open account, they may be offered a sales discount to
encourage early payment
o Discount terms are expressed as follows:
 2/10, n/30
 n = net
1 WEEK 6 COMM 2AA3
o Savings:
 With discount terms of 2/10, n/30, a customer saves $2 on a $100 purchase by
paying on the 10 day instead of the 30 day
 To save $2, have to pay $98 20 days earlier; opportunity cost
 Interest rate for 20 days = amount saved/amount paid = $2/$98 = 2.04%
o Saving $2 by sacrificing $98, 20 days earlier
 Annual Interest Rate = 365 days / 20 days x 2.04% = 37.23%
o Savings per year
 The buyer should take the discount unless
 Interest rate on their borrowed money is greater than 37.23%
 Return on their investment opportunities is greater than 37.23%
 Companies may not take advantage of discount:
 Company does not have the cash
 Can make a better investment
o Eg/ 3/20, n/45
 Interest rate for 25 days = $3/$97
 Annual Interest Rate = 365/25 x $3/$97
o Accounting for Sales Discount
 Sales and receivables are recorded at the gross amount; gross amount recording
means that business assumes that the discount will not be taken, when discount is
taken, record contra-revenue account
 Alternative; net method – assume that discount will be taken; if discount is
not taken, then reverse discount with “additional other revenue” (not taught
in this course)  more conservative
 Sales discounts taken by customers are debited to the Sales Discounts account, only
when the customer pays within the discount period
o Eg/
 On June 24, 2007, XYZ Inc. sold to ABC Inc. goods for $20,000 on credit with the
following terms (2/10, n/30)
 On July 2, 2007, ABC paid 60% of the June 24 invoice to XYZ Inc. (in discount period)
 On July 23, 2007, ABC paid the balance of their account to XYZ Inc. (outside discount
period)
 Entries:
 On the income statement
Sales revenue
Less: Credit card discounts
Sales discounts
Sales returns and allowances
Net sales
2. An exchange transaction takes place
 Payment has ben made, or on credit
3. Collection is reasonably assured
 Debt amount is collectible; goods will not be returned
 Recognize revenue, even though debt collection is not reasonably assured
o Eg/ Blackberry wrote off $946 million of recognized revenue; recognized revenue when units were
shipped to service provided, who were to ship items to customers –service providers returned
2 WEEK 6 COMM 2AA3
devices to blackberry; take them back or don’t take them back (service providers will no longer sell
blackberry products); overstated nearly $1 billion of revenue  collection is not reasonably assured
Accounting for Bad Debt
 Bad debts result from credit customers who will not pay the business the amounts they owe, regardless of collection efforts
o Certain that customer will not pay
o Can sell A/R factor to credit collection agency
 Direct Write-Off Method
o Assumes all A/R are collectible
o Recognizes bad debt expense when A/R are determined to be uncollectible (i.e. when A/R are written off)